Develop a Tax Sanctuary - The Two Pocket Exchange Strategy

Ty A. Bernicke CFP® | Posted: February 15, 2018

Originally published: 10/15/2009 (Forbes)
Updated and Republished: 02/08/18 (Bernicke Wealth Management, Ltd.)


One frequent and costly tax mistake our firm witnesses can easily be avoided by repositioning an investor’s assets. This means shifting your retirement savings from tax-inefficient investments to tax-efficient investments.

At our firm, we call this technique “The Two Pocket Exchange Strategy” as it requires shifting assets that investors already own from one pocket to another while receiving a potentially significant tax benefit. The tools to accomplish this are common and the concept is simple, yet it is rare that investors consistently exploit this strategy to its full capabilities.

Before considering this technique, consult your tax professional and make sure you understand how investments are categorized. For the sake of simplicity, it is assumed that all of your financial assets fit into one of three categories.

  1. The first category is taxable. Investments in this category can be taxed annually on interest income, capital gains and dividends. I find that even clients with modest incomes often have a large amount in these accounts from an inheritance or the sale of a house or property. Typically, you hold taxable investments in regular bank, brokerage and mutual fund accounts.

  2. The second category is tax deferred. Investments in this category frequently receive an upfront tax deduction and they grow tax deferred. Distributions are taxed at ordinary income rates, but there are no penalties when money is withdrawn for qualified reasons. By qualified, we mean money withdrawn after age 59.5 or in certain other circumstances that escape the 10% penalty from early withdrawal. Examples of these tax-deferred accounts are traditional IRAs, 401(k)s, 403b, and 457 and deferred-compensation plans.

  3. The last category is tax free. Investments in this category receive no initial tax advantage, but will grow tax free and can be withdrawn tax free in retirement. Examples include Roth IRAs, Roth 401(k)s and Roth 403bs.

The taxable category faces annual levies on dividends, capital gains and interest. While taxable accounts enjoy the benefit of a lower tax rate on capital gains, the annual tax pressure may severely handicap this category, compared to the others, when it comes to investments earmarked for future retirement income. The tax-deferred and the tax-free categories carry significant tax-reduction benefits, which frequently make these two sorts of accounts a more appealing place to hold retirement investments. Determining which of the latter two categories is ideal for your retirement money depends on your eligibility, availability and a variety of other factors outside the scope of this article.

To successfully implement the Two Pocket Exchange Strategy, an investor must constantly examine opportunities to reposition assets from the taxable category to the other categories. Here’s a hypothetical example of how this repositioning can be done.

Dick Smith is 53. His wife Jane is 51. Both work and have a combined adjusted gross income of $95,000 (Dick $55,000, Jane $40,000). For years, they have shoveled most of what they can save into their pre-tax 401(k) plans, which now total $400,000. They’ve always kept a $20,000 emergency fund in taxable accounts and recently received a $150,000 inheritance, bringing their total in taxable accounts to $170,000. Due to their concerns over tax rates rising in the future, they are considering establishing Roth IRAs and utilizing their employers’ new Roth 401(k) option. Since they are over the age of 50, they are eligible to contribute $24,500 per person a year to their Roth 401(k)s and up to $6,500 per person to their Roth IRAs (for 2018); however they can only afford to live on $10,000 less than their current take-home pay.

Here are the steps I recommend they take:

  • Establish Roth IRAs for both and immediately shift $6,500 from their taxable investments into each of their Roth IRAs.

  • Establish Roth 401(k)s for both and request maximum withholding from their employers of $24,500 per person (for 2018).

  • The Roth 401(k) contributions will result in greatly reduced paychecks. Since they can’t pay the bills with so little take-home pay, they’ll need to withdraw a comparable amount of money from their taxable-investments accounts.

  • This strategy will take almost three years to fully implement due to current limitations on contributions to the tax free Roth accounts. Once the taxable funds have been repositioned, they can reduce their 401(k) contributions back to sustainable levels until retirement.

  • Once this strategy has been fully executed, they should also consider putting a portion of their emergency reserves in an investment within their Roth IRA that is conservative and provides liquidity. A Roth IRA can double as an emergency reserve since contributions can be taken at any time, for any reason, tax and penalty free. (Earnings in the account generally cannot be withdrawn tax and penalty free until age 59.5.)

What has all this shuffling of funds accomplished? Dick and Jane Smith have permanently eliminated taxes on a minimum of $170,000 of previously taxable investments. Moreover, any Roth 401(k) or Roth IRA funds they don’t use can be left to their children, who can continue to enjoy tax-free growth for decades. (Heirs must start taking withdrawals from any inherited Roth accounts, but are allowed to spread them out over their own life expectancies.)

The point is that with a little creativity and planning, you too might be able to substantially reduce taxes on your retirement savings, as well as the tax burden on your heirs, simply by shifting savings that you already have from one pocket to another.

About the author

Ty A. Bernicke CFP®

Ty Bernicke is the President of Bernicke Wealth Management and serves as a Senior Wealth Manager. Ty currently works with a limited number of clients that require wealth and/or investment management services. His research on investment management, retirement planning, and tax minimization strategies have been published or recognized by The Wall Street Journal, Forbes, The New York Times, Futures Magazine, and many other well-known national and international publications. Ty Bernicke and Bernicke Wealth Management give back to the community and environment through numerous charitable endeavors. Ty spends his free time with his wife, two daughters, and one son. He also likes to fish, golf, and exercise.

Certifications, Licenses, and Registrations

  • Registered Principal with Triad Advisors, LLC
  • CERTIFIED FINANCIAL PLANNER™ professional
  • Accident, Life, Health, Property, Casualty, and Variable Life/Variable Annuity Insurance Licenses

Education and Training

  • Series 7, 66, 63, 24
  • Bachelors Degree - Finance; University of Wisconsin-Eau Claire
  • College for Financial Planning graduate

2019 Forbes Finance Council

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